Introduction to Macroeconomics

Chapter 26

Money, Banking and

the Federal Reserve

Money, Banking, & the Federal Reserve

1. Barter Economy

2. Characteristics of Money

3. Definition of Money

4. Fractional Reserve Banking

5. How Banks Create Money

6. Federal Reserve Policy Tools

1. Barter Economy Transaction Costs

Barter - direct trade of one good for another

Transaction Costs:– double coincidence of wants– problem of divisibility– negotiating relative values

2. Characteristic of Money General Characteristics

• Medium of Exchange - item generally acceptable as payment for goods and services. Avoids double coincidence of wants.

• Store of Value - money can be accumulated without deterioration or loss. No problem with divisibility.

• Unit of Account - money is a standard unit for quoting prices and establishing relative values. Reduces negotiation costs.

2. Characteristics of Money Commodity Money

• Characteristics:– scarce relative to other commodities– stable in supply– portable– divisible– durable

• Problems:– opportunity cost– debasing (Gresham’s Law)– can’t directly control supply

2. Characteristics of Money Representative Money

Paper money that can be exchanged for a specific commodity, like silver or gold.

Advantages:• Lower opportunity cost• Eliminates debasing

Problems:• Depends on value of underlying commodity• Counterfeiting

2. Characteristics of Money Fiat Money

Paper money that is solely money because the government says it is

Generally not backed by a valuable commodity such as god but is backed by the “full faith and credit of the government”

Advantages:• No opportunity cost• Not dependent on value of a commodity

Disadvantages• No restraint in printing money

3. Definitions of Money Categorized by Liquidity

Liquidity - how easily money can be used to make purchases

• Monetary Base - currency held by public + currency held in bank vaults (reserves)

• M1 = currency held by public plus checking deposits

• M2 = M1 + savings deposits + small (less than $100,000) time deposits (CDs)

• M3 = M2 + large (more than $100,000) time deposits

3. Definitions of Money M1

Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.

3. Definitions of Money M2

Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.

4. Fractional Reserve Banking

• Banks hold reserves (cash in their vault) that are only a fraction of their demand deposits (e.g., checking and savings accounts)

• Banks make a profit by charging a higher interest rate for loans than is paid for deposits.

4. Fractional Reserve Banking Risks

Risks:

• Bank runs

• Bank failures because of bad loans

Institutions to reduce risks:

• FDIC deposit insurance

• Federal Reserve System bank regulations

4. Fractional Reserve Banking Key Measurements

Demand Deposits (D) - total of checking and savings account

Required Reserve Ratio (r) - fraction of D established by Federal Reserve

Required Reserves, RR = r * D

Total Reserves = cash in bank vaults

Excess Reserves = Total Reserves - RR

5. How Banks Create Money Money Multiplier

• Money Multiplier = 1 / r

• Maximum Possible Increase in Money Supply= Initial change in monetary base

x money multiplier

5. How Banks Create Money Money Multiplier at Work

Cash Held by

individuals (C)

Cash in Bank Vault (R)

Total Demand Deposits

(D)

Required Reserves

(RR = r * D)

Excess Reserves (R – RR)

M1 Money Supply (C + D)

Federal Reserve Holds $100 Cash 0 0 0 0 0 0

Fed buys $100 T-Bill from individual A 100 0 0 0 0 100

Individual A deposits $100 in checking account

0 100 100 20 80 100

Bank loans excess reserves to person B 80 20 100 20 0 180

B deposits cash in checking account 0 100 180 36 64 180

Bank loans excess reserves to person C 64 36 180 36 0 244

6. Federal Reserve Policy Tools The Federal Reserve System

C om m erc ia l b an ksan d o th er d ep os ito ry

in s titu tion s

2 5 F ed era l R eserveB ran ch B an ks

1 2 F ed era l R eserve B an ks O p en M arke t C om m itteeBoard of G overn ors p lu s 5 Fed eral

Reserve Ban k p resid en ts, altern atin gterm s, New York always rep resen ted

F ed era l A d visory C ou n c il12 com m ercial b an kers

for 12 d istricts

F ederal R eserveB oard of G overnors

7 m em b ers ap p oin tedb y th e P resid en t

Created by act of Congress in 1913

6. Federal Reserve Policy Tools Policy Options

• Open Market Operations - buy and sell T-Bills

• Discount Rate - interest rate charged by Fed for overnight loans to banks

• Required Reserve Ratio

• Stock Market Margin Requirements

• Moral Persuasion

6. Federal Reserve Policy Tools Open Market Operations

Open Market Operation - purchase or sale of government securities (T-bills) on the open market

• T-Bill Par Value: cash-in value when T-Bill matures

• Interest Rate - difference between par value of T-Bill and and purchase price

6. Federal Reserve Policy Tools Expansionary Policy

• Objective: Lower Interest Rate

• Fed buys T-Bills (increase in money supply)

• Market price of T-Bills increase

• Difference between market price and par value declines.

• Result: Lower interest rate

6. Federal Reserve Policy Tools Open Market Operations

Purchase T-Bills Sell T-Bills

From Bank

From Public

From Bank

From Public

Change in Monetary Base + + - -

Initial Change in Money Supply n/c + n/c -

Max Change in Money Supply 1 / r 1 / r - 1 / r - 1 / r

Bond Prices + + - -

Interest Rate - - + +

Investment / Aggregate Demand + + - -

+ represents increase, - represents decrease

6. Federal Reserve Policy Tools Summary of Policy Options

Expansionary Policy

Contractionary Policy

Objectives:

Interest rate Lower Higher

Money Supply Higher Lower

Policies:

Open market operation Buy T-Bills Sell T-Bills

Discount rate Reduce Increase

Required reserves Reduce Increase

6. Federal Reserve Policy Tools Money and the Unemployment Rate

0

50

100

150

200

250

Jan-18

Jan-23

Jan-28

Jan-33

Jan-38

Jan-43

Jan-48

Jan-53

0

5

10

15

20

25

30

Un

em

plo

ym

en

t ra

te, p

erc

en

t

Ratio: Reserves-to-Required Reserves

Unemployment Rate

Monetary Base